One might imagine in regard to the 401(k) plans found in Lake Wobegon that all the employers are models of fiduciary conduct, all investment expenses are low and all investment returns are above average.
In the rest of the country, however, much work needs to be done to improve 401(k) investment performance. This article suggests some alternatives consultants, 401(k) providers, employers and participants might consider.
Millions of Americans have collectively lost over a half a trillion dollars, and their ability to enjoy a sustainable retirement has been dealt what for many is a death blow. Congress’ solution is legislation to improve fee disclosure and to reduce potential conflicts of interest that arise when participants receive investment advice. The financial industry solution is to advise participants to stick to their asset allocation. And the likely participant solution will be either to do nothing or to sue the employer to recover what has been lost!
To many employees, suing the employer may seem the most practicable way to restore lost wealth, and there are employers whose investment process will be found to have been lacking when compared to prudent investment practices. The plaintiff bar is already actively recruiting clients, and employers would be well advised to get a fiduciary check up. A sound fiduciary investment process not only will help to insulate employers from liability, but it also can improve investment returns.
Professional management of DC plans
This will not make plan participants more successful investors in the future, however. Neither will the same asset allocation strategies that were recommended by brokers and advisers before the market meltdown. This is because asset allocation models depend on differences in correlation between asset classes and the theory fails when all asset classes become closely correlated, as happened last year.
What’s really needed is a basic acknowledgment that participant-directed accounts don’t work. The signs were there even before the market meltdown. Ever since 401(k) plans became popular, Congress and the Department of Labor recognized that plan participants were ill-equipped to make informed and reasoned investment decisions, which is why they have regulated how plan participants should receive investment information and education. However, by proposing more of the same, they will only perpetuate the problem.
While few investors survived 2008 unscathed, there is evidence to suggest that professionally managed pension investments fared better than investments that were participant directed. According to Milliman, an actuarial and pension consulting firm, investment returns within the largest 100 U.S. pension plans were -18.9% in 2008, compared to a -28.3% median rate of return in the same year for 401(k) plans, as reported by Hewitt, another pension consulting firm. That’s a difference of almost 10%, which does not reflect the further 11% drop in the S&P 500 during the first quarter of 2009!
There is no evidence that the same employers populated both studies, but these statistics suggest that where investments are managed by investment professionals, as generally happens with pensions, particularly those of large U.S. companies, investment returns will be better. Such conclusion is supported by studies by others, such as Dalbar Inc., a Boston-based financial consulting firm, whose research indicates that average mutual fund investors tend to under-perform the market.
The solution to the problem is not to add more bells and whistles to what is an already overly complex employee benefit, but to take the investment decision out of the hands of plan participants and put it in the hands of professionals on a trustee-directed basis. This is perfectly permissible and, by following prudent investment practices, can be achieved without increasing the employer’s fiduciary exposure.
To reach this result, the plan must first be amended to make it trustee-directed. Then, the following steps should be taken:
The employer appoints a trustee who will accept responsibility for investment direction. This could be a corporate trustee or members of management.
The trustees(s) name the plan fiduciaries to manage the plan assets. The fiduciaries could be members of the investment committee that oversees the selection and monitoring of the plan’s current participant-directed investment options.
The investment committee adopts a new investment policy statement to set out the investment guidelines which will control how contributions are to be invested.
The investment committee then selects an investment manager to whom it delegates the day-to-day management of the prudent investment of the plan assets according to the new investment policy statement.
Provided the manager to whom investment authority is delegated is a Registered Investment Advisor, bank or insurance company who acknowledges in writing its fiduciary status, the plan trustees and fiduciaries are relieved of their fiduciary responsibilities for managing the assets. However, they remain responsible for prudently selecting managers, establishing appropriate investment guidelines and monitoring investment performance, just as they are for the participant-directed plan.
Different investment options
Using an investment manager does not mean that all the plan assets will be invested in a single portfolio. The investment policy statement will provide for the construction of a variety of portfolios covering a broad spectrum of risk/return attributes and the investment manager will be responsible for selecting and managing investment within those portfolios so that the needs of each plan participant can be met. Thus, an individual participant may be invested in a single portfolio or in a combination of available portfolios, depending, for example, on the number of years until retirement or on such other criteria as the investment policy statement provides.
Many plans invest in mutual funds and would expect to use mutual funds even within a trustee- directed plan. One potential wrinkle is that a mutual fund does not meet the ERISA definition of investment manager, and some would therefore argue that the use of mutual funds does not absolve fiduciaries of their investment management responsibilities.
This may be a moot point because the 401(k) rules treat mutual fund shares as plan assets and not the fractional interests in individual securities which those shares represent. This means that fiduciaries are responsible for the selection of mutual funds but not for the selection of the securities in which the mutual funds invest, which is no different from the requirement to prudently select an investment manager who does conform to the ERISA definition.
Another alternative for employers who want to help participants protect themselves from large losses is to introduce annuities as an investment option. Annuities provide a guaranteed rate of return and a guaranteed income upon retirement which can increase under some annuities if market returns exceed the guaranteed floor. However, annuities are a tax-deferred investment vehicle, and some see them as a bad idea because they potentially add cost. Critics also question why you would put one tax-deferred vehicle inside another.
The answer is because of the guaranteed income and the potential to participate in market upswings. Also, today, a variety of annuity arrangements are emerging from reputable insurance companies which are not as costly as those of yesteryear, and improvements in recordkeeping and the design of annuity products is making them increasingly more attractive as a 401(k) investment option. Such an option could be included in both a trustee-directed plan as well as one that is participant-directed.
Since plan participants don’t live in Lake Wobegon, they no doubt recognize their personal shortcomings as investors and would likely welcome these innovations. Some might be motivated enough to advocate in their favor. Few will discourage them, and this may prove to be an opportunity to boost employee morale and demonstrate an employer’s commitment to looking out for its workforce. At the very least, a dialogue would be healthy!
Roger Levy, LLM, AIFA, is CEO of Cambridge Fiduciary Services, LLC, a fiduciary advisor and audit firm with offices in Greenwich, Conn. and Scottsdale, Ariz.
